The Congressional Oversight Panel, which has been reviewing government efforts to rescue banks, released a report today, warning that bad loans and related securities remain a potential risk to the economy and small banks. Here are the key paragraphs (bold added):

If the economy worsens, especially if unemployment remains elevated or if the commercial real estate market collapses, then defaults will rise and the troubled assets will continue to deteriorate in value. Banks will incur further losses on their troubled assets. The financial system will remain vulnerable to the crisis conditions that TARP was meant to fix.

The problem of troubled assets is especially serious for the balance sheets of small banks. Small banks‘ troubled assets are generally whole loans, but Treasury‘s main program for removing troubled assets from banks‘ balance sheets, the PPIP will at present address only troubled mortgage securities and not whole loans. The problem is compounded by the fact that banks smaller than those subjected to stress tests also hold greater concentrations of commercial real estate loans, which pose a potential threat of high defaults. Moreover, small banks have more difficulty accessing the capital markets than larger banks. Despite these difficulties, the adequacy of small banks‘ capital buffers has not been evaluated under the stress tests.

Given the ongoing uncertainty, vigilance is essential. If conditions exceed those in the worst case scenario of the recent stress tests, then stress-testing of the nation‘s largest banks should be repeated to evaluate what would happen if troubled assets suffered additional losses. Supervisors should continue their increased monitoring of problem banks, and banks too weak to survive write-downs should be required to raise more capital. If PPIP participation proves insufficient, Treasury may want to consider adapting the program to make it more robust or shifting to a different strategy to remove troubled assets from the banks‘ book. Treasury should also pay special attention to the risks posed by commercial real estate loans.

Part of the financial crisis was triggered by uncertainty about the value of banks‘ loan and securities portfolios. Changing accounting standards helped the banks temporarily by allowing them greater leeway in describing their assets, but it did not change the underlying problem. In order to advance a full recovery in the economy, there must be greater transparency, accountability, and clarity, from both the government and banks, about the scope of the troubled asset problem. Treasury and relevant government agencies should work together to move financial institutions toward sufficient disclosure of the terms and volume of troubled assets on institutions‘ books so that markets can function more effectively. Finally, as noted above, Treasury must keep in mind the particular challenges
facing small banks.

The report is basically saying one cannot have an economic recovery without clearing the credit debris of the last boom. I can’t argue with that.

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